My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Monday, March 13, 2017

What Small Business Owners Need to Know - The Debits and Credits of Shareholder Loans

As an owner-manager, you can withdraw funds from your corporation as a salary and/or a dividend or as a shareholder loan. The Canada Revenue Agency (“CRA”) has incorporated strict guidelines into the Income Tax Act (”Act’) when shareholder loans have to be repaid and the tax consequences therein. These rules are often misunderstood by shareholders and can result in adverse income tax consequences where care is not taken.

The following discussion relates to situations where you have taken more shareholder loans than you have contributed to your corporation. This is often known as a shareholder “debit” as opposed to a shareholder “credit”. A shareholder credits results when your corporation owes you money, since you have advanced funds or loaned back salary or dividends in a prior year on which you were personally taxed.

The Rules

Section 15(2) of the Act outlines these rules which also encompass loans to a person or partnership who does not deal at arm’s length (i.e. family members) with the shareholder.

The basic rule for shareholder loans is that they must be repaid within one year after the end of the corporation’s taxation year in which the loan was made. For example, if you borrow money from your corporation in 2016 and the corporation's fiscal year end is December 31, 2016, the loan must be repaid by December 31, 2017. If the amount is not repaid within the time frame above, it will be added to the income of the shareholder in the year the loan was received (i.e. 2016 in this example). Therefore, a T1 adjustment may be necessary for the shareholder to correctly include the loan in income in that particular year (2016) plus accompanying interest. If anyone related to the shareholder receives the loan the amount will be included in his/her income and not the shareholder.

The Exceptions

There are some exceptions to the 15(2) shareholder loan rules which would allow the loan amount not to be included in an individual’s income. If any of the criteria below are met than 15(2) does NOT apply:

i) If the loan was repaid within one taxation year;

ii) If the loan was made in the course of a money lending business i.e. bank, and bona fide terms of repayment are made.

Employees/Shareholders Exceptions

Absent of the criteria above, certain types of loans may still be exempt from 15(2) as described below for shareholders who are also employees of their business.

If the loan is to a specified employee (person who owns directly or together with related persons more than 10% of the shares of the business) the loan must be made for one of the following purposes:

1) Purchase a home (includes a house, condo, cottage);

2) Purchase a vehicle used for employment purposes; or,

3) Purchase newly issued shares of the business.

Each of these loans must have bona fide arrangements for repayment within a reasonable time period and the loan must be provided as a result of the individual’s employment rather than shareholdings. This has generally been interpreted to mean that loans must be available to other employees who are not shareholders or related to shareholders, which could be difficult to prove if the owner is the sole employee of the business and preclude the loan where you have employees (unless you provide such loans to all other employees, which is very unlikely).

Where loans are made for a home purchase, the CRA often audits the loan and it can be problematic if not impossible to prove such a loan would have been made to other employees if there actually were such. As result of this burden of proof, where housing loans were once routinely recommended by accountants, they are now typically selectively recommended.

If the loan is to an employee-shareholder who deals at arm’s length with the corporation and together with related persons own less than 10% of the shares then the loan can be made for any purpose. This provides an exception for many employees who are minority shareholders. However, similar to specified employees above, the loan must have bona fide arrangements for repayment within a reasonable time period and the loan must be provided as a result of the individual’s employment rather than shareholdings.

Interest Benefits

Section 80.4(2) of the ITA provides for an imputed interest benefit if 15(2) does not apply. Meaning if the shareholder loan does not have to be included in income, a deemed interest benefit will still need to be reported by the individual. This interest benefit arises when the interest rate charged (if any) on the shareholder loan is less than the CRA prescribed rates per quarter - currently at 1%. The amount of the interest benefit is reduced by any interest actually paid on the loan no later than 30 days after the end of the calendar year.

If the loan is included in income by virtue of 15(2) than no imputed interest benefit would be reported.

Questions to Ask

Some of the key questions to ask when an individual shareholder or connected person (e.g. daughter) receives a loan:

1) Is it reasonable to assume the loan was received by virtue of employment?

2) Is the individual receiving the loan a specified employee? (I.e. owns more than 10% of any class of shares of the corporation). If so, was the loan made to acquire a dwelling, vehicle or shares are described above?

3) Are there bona fide terms of repayment?

If the answer is NO to any of the questions above, 15(2) applies to include the loan in income, unless the entire loan is repaid within one taxation year. Repayment of all or part of the loan that has been included in income will be eligible for a deduction by the individual on his/her personal tax return in the year of repayment.

It is very important that the loan(s) not be considered to be a series of loans and repayments or else CRA could deny the deduction upon repayment. E.g. repaying an amount at the end of 2016 only to borrow again in 2017. One of the more common ways to reduce or eliminate a shareholder loan is to convert it into a salary, bonus or dividend. Since this gives rise to taxable income, it is generally not considered to be a series of loans and repayments.

See Archived IT119R4 for more details and exceptions regarding shareholder loans.

Section 15(2) is one of the most commonly applied and misunderstood sections of the Act. You should always consult your accountant or tax specialist when dealing and planning with your shareholder loans.

I would like to thank Lorenzo Bonanno, tax manager for BDO Canada
LLP for his extensive assistance in writing this post. If you wish to
engage Lorenzo for tax planning, he can be reached at lbonanno@bdo.ca

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation.
It is written by the author solely in their personal capacity and cannot be
attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional
advice, and neither the author nor the firm with which the author is associated
shall accept any liability in respect of any reliance on the information
contained herein. Readers should always consult with their professional advisors in respect of their particular
situation. Please note the blog post is time sensitive and subject to
changes in legislation or law.

If a shareholder loan is paid back in Year 4 and there is an income deduction by virtue of s. 20(1)(j), what would happen if the amount of the loan that was paid back (and hence the deduction form income) exceeded all of the income in Year 4? Can it be carried back to prior years? Can it be carried forward?

Sorry, I have never had that issue so I have not had reason to review the situation. My gut would be you could carry it back or forward, but without reviewing the situation, I cannot provide a definitive answer so speak to your accountant and have them review to provide a definitive answer.